ARE CHINESE WALLS THE BEST SOLUTION TO THE PROBLEMS OF INSIDER TRADING AND CONFLICTS OF INTEREST IN BROKER-DEALERS?

III. CHINESE WALLS AS A WEAPON TO FIGHT INSIDER TRADING AND CONFLICTS OF INTEREST

A. Background

The Chinese Wall is the primary weapon used to combat the problems of insider trading and conflicts of interest in broker-dealers.50 Chinese Walls were initially voluntary policies and procedures established by broker-dealers themselves, but the SEC eventually made them a statutory requirement for all firms.51 The term "Chinese Wall" is a metaphor used to describe a broker-dealer's internal rules and procedures designed to prevent insider trading and manage conflicts of interest.52 A Chinese Wall attempts to "wall in" information obtained from one department and prevent this inside information from being disseminated throughout the firm.53 It also attempts to physically segregate the investment banking department from the brokerage, research and other departments of the firm.54 This segregation is designed to prevent investment bankers from exerting influence on analysts' research reports.

Chinese Walls first came into existence in 1968 as part of a settlement between the SEC and Merrill Lynch.55 Merrill Lynch was the lead underwriter for a potential public offering of debentures by Douglas Aircraft Company.56 Merrill Lynch learned that the company was about to issue a revised estimate of its earnings with substantially lower figures. Merrill Lynch's underwriters gave this information to the sales department, who in turn told several mutual funds and other large institutional clients.57 During the three-day period before Douglas publicly disclosed this information, Merrill Lynch and its clients sold the stock to avoid substantial losses.58 As part of the settlement Merrill Lynch reached with the SEC, the firm adopted a Statement of Policy that "prohibits disclosure by any member of the Underwriting Division of material information obtained from a corporation . . . and not disclosed to the investing public."59 In effect, this Statement of Policy established the first Chinese Wall.60

After the Merrill Lynch settlement, other brokerage firms voluntarily implemented Chinese Walls to prevent the SEC from targeting them in an insider trading investigation.61 However, these Chinese Walls often proved futile as numerous allegations of insider trading continued to arise.62 Congress responded by making Chinese Walls a statutory requirement under Section 15(f) of the Securities Exchange Act of 1934, which was adopted as part of the Insider Trading and Securities Fraud Enforcement Act of 1988.63 It states that "[e]very registered broker or dealer shall establish, maintain and enforce written policies and procedures reasonably designed . . . to prevent the misuse . . . of material, nonpublic information."64 This statutory requirement has been the subject of numerous SEC enforcement actions against broker-dealers.65 Therefore, broker-dealers carefully design, implement and monitor all Chinese Wall procedures to avoid SEC enforcement action.66

Although Chinese Walls exist principally to prevent insider trading, their formation serves other important purposes. One compelling benefit of Chinese Walls is to help ensure the integrity of research reports and other recommendations made by securities analysts.67 The recent emphasis on analysts' conflicts of interest has motivated the SEC, National Association of Securities Dealers, Inc. (hereinafter "NASD"), and New York Stock Exchange, Inc. (hereinafter "NYSE") to propose rules advocating the use of Chinese Walls to restore analysts' independence.68 The Chinese Wall attempts to maintain analysts' independence by separating the research and investment banking units, so that analysts are not subject to review or pressure by the investment bankers.69 The hope is that "[i]f research operates independently . . . analysts could express their true views on stocks without fear of cramping the style of investment bankers, who typically earn the bulk of most firms' income."70 Chinese Walls thus attempt to eliminate, or at least reduce, the conflict between the interests of the investment banking department and investors who rely on analysts' recommendations and research reports.